The action's in debt, not equity

There has been far too much focus on the stock markets in the media in recent days. The Guardian led its front page on Saturday with the story that the Fed had cut its discount rate in response to stock market falls. I very much doubt it, and I certainly hope not. The last thing we need is central banks trying to manipulate equity prices.

by Howard Davies
Last Updated: 31 Aug 2010
The real story is that debt markets have seized up, following the so-called sub-prime crisis (sub-prime is a highly misleading description of what are simply weak credits). Because the markets are uncertain about where the losses will ultimately fall, anyone with liquidity has been determined to hold onto it. So individually rational decisions to hold onto cash can create a collectively dangerous situation. That is the justification for central bank intervention, if the central bank is confident that the crisis is fundamentally one of liquidity, not solvency. In other words if it thinks the major banks are essentially sound.

The stock market has been affected for two reasons. First, some stock prices have been buoyed up by the prospect of private-equity led takeovers. With debt markets essentially closed those leveraged deals are much less likely. Some announced deals will almost certainly not come to fruition. And, secondly, because stock markets can be a leading indicator of trouble ahead in the real economy. There is clearly a risk that financial market turmoil will have an effect on the real economy in due course. But the fact that equity prices fall does not create any justification for intervention by the authorities.

The debt markets are the ones to watch in the next few days, not the Dow or the Footsie.

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